Insider-trading ‘scandal’ isn’t so scandalous

Investors should be shocked more firms aren’t under suspicion

With the names of three big mutual-fund companies mentioned prominently in the expanding federal probe of Wall Street insider trading, ordinary fund investors might be scared.

They shouldn’t be.

When can a tip mean jail?

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In the wake of recent FBI raids at several hedge funds, Alan Murray sat down with Joel Cohen, a former federal prosecutor and insider trading expert, to examine the complicated, and often gray world of insider trading law and prosecutions.

While scandal in the financial world is never good news — and this one is in the early stages and won’t play out for months — the current situation is unlikely to be a problem for fund investors, even if big-name players are involved. Moreover, it should give fund investors a more clear idea of what they want in a fund.

An expert networker is someone who comes up with detailed information about the inner workings of publicly traded companies, and who then sells that knowledge to money managers. The information might be some telltale clue that a company is ramping up or scaling back production — it placed or cancelled a big order for component parts, for example — or anything that, when it becomes public knowledge, might move the stock.

Because this information is not public knowledge, regulators are now asserting that sharing it with fund managers, and pushing them to profit from it, is insider trading.

Expert networks have become increasingly popular with the decline of traditional Wall Street research, where industry mergers and contraction — plus regulatory restrictions put in place in 2003 to quell the last big research scandal — have meant fewer equity analysts giving expert opinions on stocks. Up to now, there have only been questions about whether this form of research was crossing any legal lines; it fell into a gray area that, with this case, may be turning black or white.

More times than not, expert networks have been employed by hedge-fund managers; that’s true for the current case, too.

But thrown into the mix of hedge funds that average investors have never heard of were the names of Janus Capital Group, MFS Investment Management and Wellington Management Co., all named in media reports as having a relationship with an expert network at the center of the story. None of the firms involved have been accused of wrongdoing, but just being associated with a case of this nature is troubling in the eyes of many investors.

That said, fund investors should not be surprised that three firms have been implicated here, but rather should be shocked that it’s not many more.

Seeking short-term returns — and an edge

The investing public has become increasingly short-term oriented, trashing funds that can’t produce results “now.” That mindset has encouraged many fund managers to act like their hedge-fund counterparts. In hedge funds, a manager who can’t produce big profits fast typically sees all investors leave and the fund shut down after a year, two at the most.

More mutual funds now follow hedge-fund strategies. This explains the growth in market-neutral, long-short, 130/30 and other types of funds that try to incorporate moves that for decades were reserved for hedge funds.

Just as hedge-fund managers might use expert networks hoping for a quick edge, it’s natural that a traditional fund manager using similar strategies would want the same information. Moreover, even if an expert network is disseminating the inside skinny, receiving such information is not against the law; acting on it for profit is. That means all of an expert network’s clients or subscribers could be up for a regulatory look-see, if only to see who traded on the network tips.

This is not the kind of “insider-trading scandal” that the fund industry saw in 2003, when certain customers traded rapidly in and out of funds, with the rest of a fund’s shareholders paying the freight and living by rules restricting that kind of activity. This is not one investor in a fund receiving special treatment compared to another, with the manager having a financial incentive to cut the deal.

Instead, it appears to be fund managers trying to use an available, heretofore-legal information resource, presumably to improve performance for all of their shareholders. It makes you wonder why more mutual-fund managers haven’t been cited here, because you’d think they all want maximum available information on the securities they own.

Every scandal makes the investing public think that the game is rigged and hurts investor confidence but, ultimately, this investigation should help investors figure out where they want to put their money.

“Long-term investors” should want managers who research fundamentals and big-picture moves, and who aren’t concerned by a back-room rumor that might move a stock tomorrow and for the rest of the week. They don’t use expert networks because looking at the ultra-short-term takes their eyes off the ball.

Meanwhile, investors who insist that their fund try to beat the market in every time period, especially the shortest time frames, should want managers who use every available trick in the book to make magic. Regulators may take expert networks out of the trick book, but investors should not let the headlines or the hint of trouble push them out of any funds yet.

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